foreign currnecy

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PRESENTED BYSTUDENTS OF T.Y.B.Com(A&F)

Name of the student Roll. No Signature

Sanjay Acharya 01

Priya Lambda 36

Priyanka Sureka 54

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ACKNOWLEDGEMENT

We are thankful to our economics professor Shri Oberoi for giving us an opportunity to present our

economics project, in Foreign Exchange Market of India. The project enlightened our horizons

about the foreign exchange and debt market of India.

Our work on the project helped us gaining valuable information about internal debt, foreign

exchange instrument and many vital aspects. It will not only help us now but also keep us updated in

the near future.

We also thank our group members for their constructive contribution in the project .

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INDEX

SR.NO CONTENTS PG.NO

1Introd Introduction

Foreign Exchange

Foreign Exchange Market

5-7

2Market Size and Liquidity

8

3Exchange rate systems

Exchange Rate

Gold Standard System

Bretton Woods System

Smithsonian Agreement

9-11

4

Current Exchange Rates

12

5Foreign exchange transaction

Working of An FX transaction

Determination of Contract rate

13

6Market Types

Spot Market

Forward and Futures Market

14-16

7Market Participants

Government and Central Banks

Banks and other financial institutions

Hedgers

Speculators

17-18

8 Understanding the FOREX jargon 19-22

9 Exchange Rate Determinants 23-25

10 Foreign Exchange Market Risk 26-28

11 Indian foreign exchange market 29

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12 Foreign trade 30

13 How is foreign trade different from domestic trade? 31

14 Methods of payment in international trade 32-33

15 FERA & FEMA 34-38

16 Role of government in foreign exchange market 39

17 Role of central bank in foreign exchange market 40

18 Role of FEDAI in foreign exchange market 41

19 Present status of foreign exchange market 42-43

20External debt

44-46

21 Indias External debt as at the end of march 2011 47-48

22 Conclusion 49

23 Abbreviation 50

24 Bibliography 51

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INTRODUCTION

Foreign exchange

Foreign exchange, orForex, is the conversion of one country's currency into that of another. In a

free economy, a country's currency is valued according to factors of supply and demand. In otherwords, a currency's value can bepeggedto another country's currency, such as the U.S. dollar, or

even to a basket of currencies. A country's currency value also may be fixed by the country's

government. However, most countriesfloat their currencies freely against those of other countries,

which keep them in constant fluctuation.

The value of any particular currency is determined by market forces based on trade, investment,

tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay

for goods and services using the currency of the host country. Therefore, a tourist must exchange the

currency of his or her home country for the local currency. Currency exchange of this kind is one of

the demand factors for a particular currency. Another important factor of demand occurs when a

foreign company seeks to do business with a company in a specific country. Usually, the foreign

company will have to pay the local company in their local currency. At other times, it may be

desirable for an investor from one country to invest in another, and that investment would have to be

made in the local currency as well. All of these requirements produce a need for foreign exchange

and are the reasons why foreign exchange markets are so large.

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Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized

financial market for trading currencies. Financial centers around the world function as anchors of

trading between a wide range of different types of buyers and sellers around the clock, with the

exception of weekends. The foreign exchange market determines the relative values of different

currencies.

The primary purpose of the foreign exchange is to assist international trade and investment, by

allowing businesses to convert one currency to another currency. For example, it permits a US

business to import British goods and pay Pound Sterling, even though the business' income is in US

dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation

on the change in interest rates in two currencies.

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a

quantity of another currency. The modern foreign exchange market began forming during the 1970safter three decades of government restrictions on foreign exchange transactions (the Bretton Woods

system of monetary management established the rules for commercial and financial relations among

the world's major industrial states after World War II), when countries gradually switched

to floating exchange rates from the previousexchange rate regime, which remained fixed as per

the Bretton Woods system.

The foreign exchange market is unique because of:

Its huge trading volume representing the largest asset class in the world leading to

high liquidity;

Its geographical dispersion;

Its continuous operation: 24 hours a day except weekends, i.e. Trading from 20:15 gmt on

Sunday until 22:00 gmt Friday;

The variety of factors that affect exchange rates;

The low margins of relative profit compared with other markets of fixed income; and

The use ofleverage to enhance profit and loss margins and with respect to account size.

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As such, it has been referred to as the market closest to the ideal ofperfect competition,

notwithstanding currency intervention by central banks. According to the Bank for International

Settlements, as of April 2010, average daily turnover in global foreign exchange markets is

estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of

April 2007. Some firms specializing on foreign exchange market had put the average daily turnoverin excess of US$4 trillion.

The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions

$475 billion in outright forwards

$1.765 trillion in foreign exchange swaps

$43 billion Currency swaps

$207 billion in options and other products

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MARKET SIZE AND LIQUIDITY

Main foreign exchange market turnover, 19882007, measured in billions of USD.

The foreign exchange market is the most liquid financial market in the world. Traders include large

banks,central banks, institutional investors, currency speculators, corporations, governments,

otherfinancial institutions, and retail investors. The average daily turnover in the global foreign

exchange and related markets is continuously growing. According to the 2010 Triennial Central

Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was

US$3.98 trillion in April 2010 (v/s $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot

foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other

currencyderivatives.

Trading in the UKaccounted for 36.7% of the total, making UK by far the most important global

center for foreign exchange trading. In second and third places, respectively, trading in

the USAaccounted for 17.9%, and Japan accounted for 6.2%.

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EXCHANGE RATE SYSTEMS

Exchange rate

Infinance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate)

between two currencies is the rate at which one currency will be exchanged for another. It is also

regarded as the value of one countrys currency in terms of another currency. For example, an

interbank exchange rate of 91 Japanese yen(JPY, ) to the United States dollar(US$) means that

91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates

are determined in theforeign exchange market, which is open to a wide range of different types of

buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e.

trading from 20:15GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the

current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and

traded today but for delivery and payment on a specific future date.

In the retail currency exchange market, the actual buying rate and selling rate quoted by money

dealers will usually be different. The buying rate is the rate at which money dealers will buy foreign

currency, and the selling rate is the rate at which they will sell the currency. Most trades are to or

from the local currency. The quoted rates will incorporate an allowance for a dealer's margin (or

profit) in trading, or else the margin may be recovered in the form of a "commission" or in some

other way. Different rates may also be quoted for cash (usually notes only), a documentary form

(such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate ondocumentary transactions is due to the additional time and cost of clearing the document; while the

cash is available for resale immediately.

There are variations in the quoted buying and selling rates for a currency, and these variations can

be significant. For example, consumer exchange rates used by Visaand MasterCardoffer the most

favorable exchange rates available, according to a Currency Exchange Study conducted

byCardHub.com. This study, which examined the U.S. dollar-to-Euro exchange rates provided by

the major worldwide credit card networks, 15 of the largest consumer banks in the U.S.,

and Travelex, showed that the credit card networks save travelers about 8% relative to banks and

roughly 15% relative to airport companies.

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Exchange R ate syste ms

Gold Standard System

The creation of theG old standard monetary system in 1875 marks one of the most important events

in the history of the forex market. Before the gold standard was implemented, countries would

commonly use gold and silver as means of international payment. The main issue with using gold

and silver for payment is that their value is affected by external supply and demand. For example,

the discovery of a new gold mine would drive gold prices down.

The underlying idea behind the gold standard was that governments guaranteed the conversion of

currency into a specific amount of gold, and vice versa. In other words, a currency would be backed

by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the

demand for currency exchanges. During the late nineteenth century, all of the major economic

countries had defined an amount of currency to an ounce of gold. Over time, the difference in price

of an ounce of gold between two currencies became the exchange rate for those two currencies. This

represented the first standardized means of currency exchange in history.

The gold standard eventually broke down during the beginning of World War I. Due to the political

tension with Germany, the major European powers felt a need to complete large military projects.

The financial burden of these projects was so substantial that there was not enough gold at the time

to exchange for all the excess currency that the governments were printing off.

Although the gold standard would make a small comeback during the inter-war years, most

countries had dropped it again by the onset of World War II. However, gold never ceased being the

ultimate form of monetary value.

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Bretton Woods System

Before the end of World War II, the Allied nations believed that there would be a need to set up a

monetary system in order to fill the void that was left behind when the gold standard system was

abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton

Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of

international monetary management.

To simplify, Bretton Woods led to the formation of the following:

A method of fixed exchange rates;

The U.S. dollar replacing the gold standard to become a primary reserve currency; and

The creation of three international agencies to oversee economic activity: the International

Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General

Agreement on Tariffs and Trade (GATT).

One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main

Standard of convertibility for the worlds currencies; and furthermore, the U.S. dollar

became the only currency that would be backed by gold. (This turned out to be the primary

reason that Bretton Woods eventually failed.)

Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order

to be the worlds reserved currency. By the early 1970s, U.S. gold reserves were so depleted that

the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central banks

had in reserve.

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and

the U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that

were held in foreign reserves. This event marked the end of Bretton Woods.

Even though Bretton Woods didnt last, it left an important legacy that still has a significant

effect on todays international economic climate. This legacy exists in the form of the three

international agencies created in the 1940s: the IMF, the International Bank for Reconstruction

and Development (now part of the World Bank) and GATT, the precursor to the World Trade

Organization.

Smithsonian Agreement

The Smithsonian Agreement was a December 1971 agreement that ended the fixed exchange

rates established at the Bretton Woods Conference of 1944.

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CURRENT EXCHANGE RATES

After the Bretton Woods system broke down, the world finally accepted the use of floating foreign

exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard

would be permanently abolished. However, this is not to say that governments adopted a pure free-

floating exchange rate system. Most governments employ one of the following three exchange rate

systems that are still used today:

Dollarization;

Pegged rate; and

Managed floating rate.

Dollarization

This event occurs when a country decides not to issue its own currency and adopts a foreign

currency as its national currency. Although dollarization usually enables a country to be seen as a

more stable place for investment, the drawback is that the countrys central bank can no longer print

money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the

U.S. dollar.

Pegged Rates Or Fixed Exchange Rate System

Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the

country will have somewhat more stability than a normal float. More specifically, pegging allows a

countrys currency to be exchanged at a fixed rate with a single or a specific basket of foreign

currencies. The currency will only fluctuate when the pegged currencies change.For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997

and July 21, 2005. The downside to pegging would be that a currencys value is at the mercy of the

pegged currencys economic situation. For example, if the U.S. dollar appreciates substantially

against all other currencies, the yuan would also appreciate, which may not be what the Chinese

central bank wants.

Managed Floating Rates

This type of system is created when a currencys exchange rate is allowed to freely change in value

subject to the market forces of supply and demand. However, the government or central bank may

intervene to stabilize extreme fluctuations in exchange rates. For example, if a countrys currency is

depreciating far beyond an acceptable level, the government can raise short-term interest rates.

Raising rates should cause the currency to appreciate slightly; but understand that this is a very

simplified example. Central banks typically employ a number of tools to manage currency.

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FOREIGN EXCHANGE TRANSACTION

An FX transaction may be useful in managing the currency risk associated with importing or

exporting goods and services denominated in foreign currency, investing or borrowing overseas,

repatriating profits, converting foreign currency denominated dividends, or settling other foreigncurrency contractual arrangements.

Working of an FX transaction

When you enter into an FX transaction, you nominate the amount (the contract amount) and the two

currencies to be exchanged. These currencies are known as the currency pair and must be acceptable

to your foreign exchange provider.

You also nominate the maturity date on which you want the exchange of currencies to take place.

Your FX provider will then determine the exchange rate, known as the contract rate, based on thedate and currencies nominated by you. The contract rate is the rate at which the currencies will be

exchanged.

On the contract date the contract amount must be exchanged with your FX provider at the contract

rate, irrespective of where the foreign exchange rate is at the time.

Determination of Contract Rate

It is the agreed exchange rate at which the currency pair will be exchanged on the date of maturity.

Your currency provider determines the contract rate, taking several factors into account including:

the currency pair and the time zone you choose to trade in

the maturity date set by you

inter-bank spot foreign exchange rates

the contract amount, and your currency providers ability to trade small amounts on the inter-

bank market

market volatility

Inter-bank interest rates of the countries of the currency pair.

Contract rates are quoted as spot exchange rates, value today exchange rates, value tomorrowexchange rates, or forward exchange rates, depending on the maturity date nominated by you.

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MARKET TYPES

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade forex: the spot

market, the forwards market and the futures market. The forex trading in the spot market always has

been the largest market because it is the "underlying" real asset that the forwards and futures

markets are based on. In the past, the futures market was the most popular venue for traders because

it was available to individual investors for a longer period of time. However, with the advent of

electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the

futures market as the preferred trading market for individual investors and speculators. When people

refer to the forex market, they usually are referring to the spot market. The forwards and futures

markets tend to be more popular with companies that need to hedge their foreign exchange risks out

to a specific date in the future.

What is the spot market?

More specifically, the spot market is where currencies are bought and sold according to the current

price. That price, determined by supply and demand, is a reflection of many things, including

currentinterest rates, economic performance, sentiment towards ongoing political situations (both

locally and internationally), as well as the perception of the future performance of one currency

against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction

by which one party delivers an agreed-upon currency amount to the counter party and receives a

specified amount of another currency at the agreed-upon exchange rate value. After a position is

closed, the settlement is in cash. Although the spot market is commonly known as one that deals

with transactions in the present (rather than the future), these trades actually take two days for

settlement.

What are the forwards and futures markets?

Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they

deal in contracts that represent claims to a certain currency type, a specific price per unit and a

future date for settlement. In the forwards market, contracts are bought and sold OTC between two

parties, who determine the terms of the agreement between themselves.

Futures market

This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon

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today for a given asset.

At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided

quantity of the given asset at the pre-decided price. Similarly, the seller of the futures contract gives

the delivery of the pre-decided quantity of the given asset at the pre-decided price.

In a futures contract, both the buyer and seller are bound to honour their commitment thebuyerhas to take delivery, and the sellerhas to make delivery according to the terms of the contract.

Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the

pre-decided price. And even if the price goes up, the seller has to give the seller at the pre-decided

price. There is no upfront cost involved in the purchase of a futures contract, apart from brokerage.

Example: A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price

is Rs. 3200 and the expiry date is 3 months away.

Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would

deliver 200 shares of Reliance Industries to B at Rs. 3200.

Options

As the name suggests, here, the buyer has an option to take delivery of the asset, and not the

obligation. Thus, if the market price of the asset goes up, and buyer of an option would exercise the

option and get profits. But if the market price of the asset goes down, the buyer of the option would

not exercise it, and would allow the option to lapse.

Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has

the obligation to deliver the assets if the buyer chooses to exercise the option.

In case of options, the pre-decided price for the exchange of asset is called the Strike Price.

One thing to remember though is that in reality, not many people actually exercise their options

people do not actually exchange the asset at the time of exercise. Since the options are traded in the

market, instead of exercising them, the buyers just sell them in the market.The logic behind this when an option is in the money (that is, when it becomes profitable for the

buyer), its option premium or the price goes up. So, one can sell it and make profit instead of

exercising it. This is easier, and therefore is done by most people.

American and European Options

The options are of two types American and European. In American options, the option can be

exercised any time upto the settlement date. In European options, the option can be exercised

only on the settlement date. Thus, American options are much more flexible (In India, only

American options are traded).

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Cost

There is a cost involved for options the buyer of the option has to pay the seller an Option

Premium, which is the fee the option seller (also called the Option Writer) gets in return for the

one-sided guarantee he extends to the buyer. Since the option writer assumes the risk of the price

movement, this fee is well justified.

Example: A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price

is Rs. 3200 and the expiry date is 3 months away. The option premium is Rs. 25.

Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this

case, B would exercise the option, and would get the shares at Rs. 3200 from A.

Thus, B would make a profit of Rs. 3400 Rs. 3200 Rs. 25 (Option premium) = Rs. 175.

Similarly, A would make a loss of Rs. 175.

But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B

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would not exercise the option. In this case, the option buyer B would make a loss equal to the option

premium Rs. 25 in this case, and the option writer would make a profit equal to the option

premium Rs. 25.

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MARKET PARTICIPANTS

Unlike the equity market - where investors often only trade with institutional investors (such as

mutual funds) or other individual investors - there are additional participants that trade on the forex

market for entirely different reasons than those on the equity market. Therefore, it is important to

identify and understand the functions and motivations of the main players of the forex market.

Governments and Central Banks

Arguably, some of the most influential participants involved with currency exchange are the central

banks and federal governments. In most countries, the central bank is an extension of the

government and conducts its policy in tandem with the government. However, some governments

feel that a more independent central bank would be more effective in balancing the goals of curbing

inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the

degree of independence that a central bank possesses, government representatives typically haveregular consultations with central bank representatives to discuss monetary policy. Thus, central

banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic

goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been

buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target

exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With

extremely deep pockets, they yield significant influence on the currency markets.

Banks and Other Financial Institutions

In addition to central banks and governments, some of the largest participants involved with forex

transactions are banks. Most individuals who need foreign currency for small-scale transactions deal

with neighborhood banks. However, individual transactions pale in comparison to the volumes that

are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and

determine the currency price that individual traders see on their trading platforms. These banks

transact with each other on electronic brokering systems that are based upon credit. Only banks that

have credit relationships with each other can engage in transactions. The larger the bank, the morecredit relationships it has and the better the pricing it can access for its customers. The smaller the

bank, the less credit relationships it has and the lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the

bid/ask price. One way that banks make money on the forex market is by exchanging currency at a

premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is

common to see different banks with slightly different exchange rates for the same currency.

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Hedgers

Some of the biggest clients of these banks are businesses that deal with international transactions.

Whether a business is selling to an international client or buying from an international supplier, it

will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal

with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a

German company orders some equipment from a Japanese manufacturer to be paid in yen one year

from now. Since the exchange rate can fluctuate wildly over an entire year, the German company

has no way of knowing whether it will end up paying more euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into

the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not

want to hold massive amounts of foreign currency for long periods of time. Therefore, businessesquite frequently employ hedging strategies in order to lock in a specific exchange rate for the future

or to remove all sources of exchange-rate risk for that transaction. For example, if a European

company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the

euro falls against the dollar before payment is made, the European company will realize a financial

loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the

risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators

Another class of market participants involved with foreign exchange-related transactions isspeculators. Rather than hedging against movement in exchange rates or exchanging currency to

fund international transactions, speculators attempt to make money by taking advantage of

fluctuating exchange-rate levels. The most famous of all currency speculators is probably George

Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the

British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson,

a derivatives trader with Englands Barings Bank, took speculative positions on futures contracts in

yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the

company.

Some of the largest and most controversial speculators on the forex market are hedge funds, which

are essentially unregulated funds that employ unconventional investment strategies in order to reap

large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping

boys of many a central banker. Given that they can place such massive bets, they can have a major

effect on a countrys currency and economy. Some critics blamed hedge funds for the Asian

currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness

of Asian central bankers. Either way, speculators can have a big sway on the currency markets,

particularly big ones. Now that you have a basic understanding of the forex market, its participants

and its history, we can move on to some of the more advanced concepts that will bring you closer to

being able to trade within this massive market. The next section will look at the main economictheories that underlie the forex market.

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UNDERSTANDING THE FOREX JARGON

Reading a Quote

When a currency is quoted, it is done in relation to another currency, so that the value of one is

reflected through the value of another. Therefore, if you are trying to determine the exchange rate

between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:

This is referred to as a currency pair. The currency to the left of the slash is thebase currency, while

the currency on the right is called the quote or counter currency. The base currency (in this case,

the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in thiscase, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote

means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The

forex quote includes the currency abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, eitherdirectly orindirectly. A direct currency quote is

simply a currency pair in which the domestic currency is the base currency; while an indirect quote,

is a currency pair where the domestic currency is the quoted currency. So if you were looking at the

Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quotewould be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the

foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect

quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one

unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which

means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse

(1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is

frequently the base currency in the currency pair. In these cases, it is called a direct quote. This

would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50

Japanese yen. However, not all currencies have the U.S. dollar as the base. The Queen's currencies -

those currencies that historically have had a tie with Britain, such as the British pound, Australian

Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The

euro, which is relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the

counter currency, and the exchange rate is referred to as an indirect quote. This is why the

EUR/USD quote is given as 1.25, for example, because it means that one euro is the equivalent of

1.25 U.S. dollars. Most currency exchange rates are quoted out to four digits after the decimal place,with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

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Cross Currency

When a currency quote is given without the U.S. dollar as one of its components, this is called

a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and

EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is

important to note that they do not have as much of a following (for example, not as actively traded)

as pairs that include the U.S. dollar, which also are called the majors.

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is abid

price (buy) and an ask price(sell). Again, these are in relation to the base currency. When buying a

currency pair (goinglong), the ask price refers to the amount of quoted currency that has to be paid

in order to buy one unit of the base currency, or how much the market will sell one unit of the base

currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted

currency will be obtained when selling one unit of the base currency, or how much the market will

pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price

(only the last two digits of the full price are typically quoted). Note that the bid price is always

smaller than the ask price. Let's look at an example:

If you want to buy this currency pair, this means that you intend to buy the base currency and are

therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for

U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars.However, in order to sell this currency pair, or sell the base currency in exchange for the quoted

currency, you would look at the bid price. It tells you that the market will buy US$1 base currency

(you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars,

which is the quoted currency. Whichever currency is quoted first (the base currency) is always the

one in which the transaction is being conducted. You either buy or sell the base currency.

Depending on what currency you want to use to buy or sell the base with, you refer to the

corresponding currency pairspot exchange rate to determine the price.

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Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were to look at the

following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3pips, also known as

points. Although these movements may seem insignificant, even the smallest point change can result

in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons

thatspeculators are so attracted to the forex market; even the tiniest price movement can result in

huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S.

dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip

would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of

USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to

150 pips a day.

Currency Quote Overview

USD/CAD = 1.2232/37

Base Currency Currency to the left (USD)

Quote/Counter

CurrencyCurrency to the right (CAD)

Bid Price 1.2232

Price for which the market maker

will buy the base currency. Bid is

always smaller than ask.

Ask Price 1.2237Price for which the market maker

will sell the base currency.

Pip

One point move, in USD/CAD it is .

0001 and 1 point change would be

from 1.2231 to 1.2232

The pip/point is the smallest

movement a price can make.

Spread

Spread in this case is 5 pips/points;

difference between bid and ask

price (1.2237-1.2232).

Currency Pairs in the Forwards and Futures Markets

One of the key technical differences between the forex markets is the way currencies are quoted. In

the forwards or futures markets, foreign exchange always is quoted against the U.S. dollar. This

means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other

currency. Remember that in the spot market some currencies are quoted against the U.S. dollar,

while for others, the U.S. dollar is being quoted against them. As such, the forwards/futures market

and the spot market quotes will not always be parallel one another.

For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD.

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This is the same way it would be quoted in the forwards and futures markets. Thus, when the British

pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and

futures markets.

On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the

former is quoted against the latter. In the spot market, the quote would be 115 for example, whichmeans that one U.S. dollar would buy 115 Japanese yen. In the futures market, it would be quoted as

(1/115) or .0087, which means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in

the USD/JPY spot rate would equate to a decline in the JPY futures rate because the U.S. dollar

would have strengthened against the Japanese yen and therefore one Japanese yen would buy less

U.S. dollars.

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EXCHANGE RATE DETERMINANTS

The following theories explain the fluctuations in FX rates in afloating exchange rate regime (In

a fixed exchange rate regime, FX rates are decided by its government):

International parity conditions :

Relative Purchasing Power Parity,interest rate parity, Domestic Fisher effect,International

Fisher effect. Though to some extent the above theories provide logical explanation for the

fluctuations in exchange rates, yet these theories falter as they are based on challengeable

assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real

world.

Balance of payments model :

This model, however, focuses largely on tradable goods and services, ignoring the increasing

role of global capital flows. It failed to provide any explanation for continuous appreciation of

dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

Asset market model :

Views currencies as an important asset class for constructing investment portfolios. Assets prices

are influenced mostly by people's willingness to hold the existing quantities of assets, which in

turn depends on their expectations on the future worth of these assets. The asset market model of

exchange rate determination states that the exchange rate between two currencies represents the

price that just balances the relative supplies of, and demand for, assets denominated in those

currencies.

None of the models developed so far succeed to explain FX rates levels and volatility in the longer

time frames. For shorter time frames (less than a few days) algorithms can be devised to predict

prices. It is understood from the above models that many macroeconomic factors affect the

exchange rates and in the end currency prices are a result of dual forces of demand and supply. The

world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of

current events, supply and demand factors are constantly shifting, and the price of one currency in

relation to another shifts accordingly. No other market encompasses (and distills) as much of what is

going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single

element, but rather by several. These elements generally fall into three categories: economic factors,

political conditions and market psychology.

Economic factors

These include: (a)economic policy, disseminated by government agencies and central banks,

(b)economic conditions, generally revealed through economic reports, and othereconomic

indicators.

Economic policy comprises government fiscal policy(budget/spending practices) andmonetary

policy (the means by which a government's central bank influences the supply and "cost" of money,which is reflected by the level ofinterest rates).

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Government budget deficits or surpluses: The market usually reacts negatively to widening

governmentbudget deficits, and positively to narrowing budget deficits. The impact is reflected in

the value of a country's currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand forgoods and services, which in turn indicates demand for a country's currency to conduct trade.

Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's

economy. For example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends: Typically a currency will lose value if there is a high level ofinflation in

the country or if inflation levels are perceived to be rising. This is because inflation

erodespurchasing power, thus demand, for that particular currency. However, a currency may

sometimes strengthen when inflation rises because of expectations that the central bank will raise

short-term interest rates to combat rising inflation.

Economic growth and health: Reports such as GDP, employmentlevels, retail sales, capacity

utilization and others, detail the levels of a country's economic growth and health. Generally, the

more healthy and robust a country's economy, the better its currency will perform, and the more

demand for it there will be.

Productivity of an economy: Increasing productivity in an economy should positively influence the

value of its currency. Its effects are more prominent if the increase is in the traded sector.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on

currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling

party. Political upheaval and instability can have a negative impact on a nation's economy. For

example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the

value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a

political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events

in one country in a region may spur positive/negative interest in a neighboring country and, in the

process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of

ways:

Flights to quality: Unsettling international events can lead to a "flight to quality", a type ofcapital

flight whereby investors move their assets to a perceived "safe haven". There will be a greater

demand, thus a higher price, for currencies perceived as stronger over their relatively weaker

counterparts. TheU.S. dollar, Swiss franc and gold have been traditional safe havens during times of

political or economic uncertainty.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do

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not have an annual growing season like physical commodities,business cyclesdo make themselves

felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the

tendency for the price of a currency to reflect the impact of a particular action before it occurs and,when the anticipated event comes to pass, react in exactly the opposite direction. This may also be

referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also

be an example of the cognitive bias known asanchoring, when investors focus too much on the

relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports

and numbers take on a talisman-like effect: the number itself becomes important to market

psychology and may have an immediate impact on short-term market moves. "What to watch" can

change over time. In recent years, for example, money supply, employment, trade balance figures

and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a

currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many

traders study price charts in order to identify such patterns.

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FOREIGN EXCHANGE MARKET RISK

What are the different risks associated with foreign exchange that an individual or corporate

is exposed to?

A part from the fluctuations in the rate of exchange, there are many other risks to which aperson/corporate dealing in foreign exchange is exposed to. We could broadly categorize them as

under

Transaction risk

Position risk

Credit risk

Maturity mismatch

Country risks

Frauds

Operational risks

Transaction Risk

The risk is inherent in all foreign currency transaction. These could be

Trading items-like trade receivables and payables in foreign currencies.

Capital item-foreign currency loans, dividend and interest payment in foreign currency,

equipment purchase designated in foreign currency.

Let us assume that a company has to receive US$10000 for goods which it has exported after a

month. If in means while the US$ depreciates, the company would receive much less than what

it had planned for.

Control Aspects: The transaction risk is controlled by helping, which is, by covering the risks

involved by buying a suitable forex product like forward contract, LTFC, or other derivative

Products.

Position risk

The banks face this type of risk. Banks deal with their customers continuously, purchasing/selling

foreign exchange. This results in the creation of a position. A position risk occurs when the dealer in

a bank has an overbought (long) position or an oversold (short) position. These positions are entered

into deliberately in anticipation of favorable movements in the rates. This position risk, also called

open position risk, in inevitable for the following reasons

The dealing rooms may not get reports of the purchases/sales of all the currency since

o

Smaller purchases and sales are not reported.

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o Larger deals may fail to get reported due to communication problems.

o There could be wrong reporting

Operations in the inter-bank are done in round sums, and absolutely square position (i.e.

where purchase and sale of a currency is equal) are impossible to maintain as aggregate

customer transactions will rarely result in marketable lots.

Some imbalance may be because the bank is unable to carry out cover operations in the

inter-bank market which could be due to the absence of a counter party for the same tenor and

volume for a currency.

Control Aspects: The bank adopts the following internal control systems

Day-light Limits or Intra-day Limit for each currency. This is the limit upto which the dealer

himself can deal can deal himself without reference to higher authorities. For example, if thebank has fixed a day-light limit of US$10 million, it means that the dealer can purchase and sell

dollars as long as the balance outstanding at any given point of time is less than US$10 million.

Overnight Limits: The extent to which the currency position can be kept open at the end of

the day. Normally the overnight limits are much lower than the day-light limits. These limits are

for individual currency. Apart this you have aggregate limits on foreign exchange position for all

the currencies put together.

Cut-Loss Limits: This is fixed to restrict loss due to adverse movement in the exchange rates.

Credits Risks

Credit risk is the risk of failure of the counterparty to the contract. Credit risk can be classified:

Pre-settlement risk: in this case the failure of the counterparty is known to the bank even

before it (bank) executes its part of the contract. Thus a bank, is exposed to risk if on the due

date the customers does not take delivery of the currency, whereas its own obligation under the

forward purchase contract, which it must have booked position, must be fulfilled. The loss to the

bank has to cover the gap arising from the non-performance of the counter party.

Settlement risk: This rises when the bank has fulfilled its part in the contract but the

counterparty does not. The loss in the case is not only the exchange differences but the entire

fund that has been deployed. Settlement risk arises due to time differences at different centers.

Control Aspects: The risk is controlled by fixing counterparty limits, both of the bank and the

Merchant customers.

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Maturity Mismatch Risk

The risk arise son account of the maturity period of purchase and sale contracts not coinciding or

matching. There could any number of reasons for mismatch-

Under a forward contract the customer may exercise the opinion of taking delivery or giving

delivery, but the cover contract with the market will be at some other date.

Non-availability of a matching forward contract of same tenor and volume.

Small value merchants contracts mat not aggregate to round sums for which cover is

available in the market.

The mismatches may be covered with a swap deal. But risks involved may be high.

Control Aspects: At monthly intervals the purchase and the sales are aggregated maturity-wise andthe net balance is arrived at, and permissible gap limits are stipulated, which limits are fixed for

individual currency. Cumulative gap limits are stipulated for all maturities for each currency and

also for all currencies. This, to a certain extent, controls the risk due mismatches.

Country Risk

This is also known as the sovereign risk or transfer risk. This relates to the ability of the country to

service its external liabilities. It refers to the possibility of government or borrowers defaulting for

reasons which are beyond the usual credit risk.

Control aspects: the country risk analysis is made taking into consideration political, economical

and social situations prevailing in the country, and a limit for the exposure to that country is fixed.

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Frauds

Frauds may be indulged in by the dealers or operational staff for personal gains or for covering up

genuine mistakes committed earlier. Frauds could also be committed by the dealer putting through

the transaction for his own benefits without routing them through banks book.

Control aspects: Regular follow up of deal slips and contract confirmation.

Surprise checks, inspections and on going auditing.

Separation of dealings and back offices.

Proper maintenance of up-to-date records of currency position, exchange position and

counter party registers.

Operational risks

This covers all other types of risks which are not categorized above. These include inadvertent

mistakes in rates, double reporting, and wrong applications of funds. These may creep in due to

human error or deficient administration.

Control aspects:

Regular follow up of deal slips and contract confirmation.

Surprise checks, inspections and on going auditing.

Separation of dealings and back offices.

Proper maintenance of up-to-date records of currency position, exchange position and

counter party registers.

INDIAN FOREIGN EXCHANGE MARKET

The Indian foreign exchange (forex) market consists of the buyers, sellers, market intermediaries

and the monetary authority of India. The main center of foreign exchange transactions in India is

Mumbai, the commercial capital of the country. There are several other centers for foreign exchange

transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry andCochin. In past, due to lack of communication facilities all these markets were not linked. But with

the development of technologies, all the foreign exchange markets of India are working collectively.

The foreign exchange market India is regulated by the reserve bank of India through the Exchange

Control Department. At the same time, Foreign Exchange Dealers Association (voluntary

association) also provides some help in regulating the market. The Authorized Dealers (Authorized

by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in

India. When the foreign exchange trade is going on between Authorized Dealers and RBI or

between the Authorized Dealers and the Overseas banks, the brokers have no role to play.

Apart from the Authorized Dealers and brokers, there are some others who are provided with the

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restricted rights to accept the foreign currency or travelers cheque. Among these, there are

authorized money changers, travel agents, certain hotels and government shops.

The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act,

1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign

Exchange Regulation Act, 1947. After independence, FERA was introduced as a temporary measureto regulate the inflow of the foreign capital. But with the economic and industrial development, the

need for conservation of foreign currency was felt and on the recommendation of the Public

Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973

and gradually, this act became famous as FEMA.

FOREIGN TRADE

Foreign trade can be considered a number of different things, depending on the type of trade one is

talking about. Generally speaking, foreign trade means trading goods and services that are destined

for a country other than their country of origin. Foreign trade can also be investing

in foreign securities, though this is a less common use of the term.

Foreign trade is all about imports and exports. The backbone of any foreign trade between nations is

those products and services which are being traded to some other location outside a particular

country's borders. Some nations are adept at producing certain products at a cost-effective price.

Perhaps it is because they have the labor supply or abundant natural resources which make up the

raw materials needed. No matter what the reason, the ability of some nations to produce what other

nations want is what makes foreign trade work.

In some cases, the products produced in a foreign trade situation are very similar to other products

being produced around the world, at least in their raw form. Therefore, these products, known as

commodities, are often pooled together in one mass market and sold. This is called trading

commodities. The most common commodities often sold in foreign trade are oil and grain.

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FOREIGN TRADE: DIFFERENT FROM DOMESTIC TRADE

The following are the major differences between domestic trade and foreign trade:-

Mobility in Factor Of Production

Domestic Trade: Free to move around factors of production like land, labor, capital and laborcapital and entrepreneurship from one state to another within the same country

International Trade: Quite restricted

Movement of goods

Domestic trade: easier to move goods without many restrictions. Maybe need to pay sales

tax, etc.

International Trade: Restricted due to complicated custom procedures and trade barriers like

tariff, quotas or embargo

Usage of different currencies

Domestic trade: same type of currency used

International trade: different countries used different currencies

Broader markets

Domestic trade: limited market due to limits in population, etc

International trade: Broader markets

Language And Cultural Barriers

Domestic trade: speak same language and practice same culture

International trade: Communication challenges due to language and cultural barriers

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METHODS OF PAYMENT IN INTERNATIONAL TRADE

There are 3 standard ways of payment methods in the export import trade international trade market:

Clean Payment Collection of Bills

Letters of Credit L/c

Clean Payments

In clean payment method, all shipping documents, including title documents are handled directly

between the trading partners. The role of banks is limited to clearing amounts as required. Clean

payment method offers a relatively cheap and uncomplicated method of payment for both importers

and exporters.

There are basically two types of clean payments:

Advance Payment

In advance payment method the exporter is trusted to ship the goods after receiving payment from

the importer.

Open Account

In open account method the importer is trusted to pay the exporter after receipt of goods.The main drawback of open account method is that exporter assumes all the risks while the importer

get the advantage over the delay use of company's cash resources and is also not responsible for the

risk associated with goods.

Payment Collection of Bills in International Trade

The Payment Collection of Bills also called Uniform Rules for Collections is published by

International Chamber of Commerce (ICC) under the document number 522 (URC522) and is

followed by more than 90% of the world's banks.

In this method of payment in international trade the exporter entrusts the handling of commercial

and often financial documents to banks and gives the banks necessary instructions concerning the

release of these documents to the Importer. It is considered to be one of the cost effective methods

of evidencing a transaction for buyers, where documents are manipulated via the banking system.

There are two methods of collections of bill:

Documents Against Payment D/P

In this case documents are released to the importer only when the payment has been done.

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Documents Against Acceptance D/A

In this case documents are released to the importer only against acceptance of a draft.

Letter of Credit L/c

Letter of Credit also known as Documentary Credit is a written undertaking by the importers bank

known as the issuing bank on behalf of its customer, the importer (applicant), promising to effect

payment in favor of the exporter (beneficiary) up to a stated sum of money, within a prescribed time

limit and against stipulated documents. It is published by the International Chamber of Commerce

under the provision of Uniform Custom and Practices (UCP) brochure number 500.

Various types of L/Cs are:

Revocable & Irrevocable Letter of Credit (L/c)

A Revocable Letter of Credit can be cancelled without the consent of the exporter.

An Irrevocable Letter of Credit cannot be cancelled or amended without the consent of all parties

including the exporter.

Sight & Time Letter of Credit

If payment is to be made at the time of presenting the document then it is referred as the Sight Letter

of Credit. In this case banks are allowed to take the necessary time required to check the documents.

If payment is to be made after the lapse of a particular time period as stated in the draft then it is

referred as the Term Letter of Credit.

Confirmed Letter of Credit (L/c)

Under a Confirmed Letter of Credit, a bank, called the Confirming Bank, adds its commitment to

that of the issuing bank. By adding its commitment, the Confirming Bank takes the responsibility of

claim under the letter of credit, assuming all terms and conditions of the letter of credit are met.

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FERA AND FEMA

In India, all transactions that include foreign exchange were regulated by Foreign Exchange

Regulations Act (FERA),1973. The main objective of FERA was conservation and proper utilizationof the foreign exchange resources of the country. It also sought to control certain aspects of the

conduct of business outside the country by Indian companies and in India by foreign companies. It

was a criminal legislation which meant that its violation would lead to imprisonment and payment of

heavy fine. It had many restrictive clauses which deterred foreign investments.

In the light of economic reforms and the liberalized scenario, FERA was replaced by a new Act

called the Foreign Exchange Management Act (FEMA),1999.The Act applies to all branches,

offices and agencies outside India, owned or controlled by a person resident in India. FEMA

emerged as an investor friendly legislation which is purely a civil legislation in the sense that its

violation implies only payment of monetary penalties and fines. However, under it, a person will beliable to civil imprisonment only if he does not pay the prescribed fine within 90 days from the date

of notice but that too happens after formalities of show cause notice and personal hearing. FEMA

also provides for a two year sunset clause for offences committed under FERA which may be taken

as the transition period granted for moving from one 'harsh' law to the other 'industry friendly'

legislation.

Broadly, the objectives ofFEMA are: (i) To facilitate external trade and payments; and (ii) To

promote the orderly development and maintenance of foreign exchange market. The Act has

assigned an important role to the Reserve Bank of India (RBI) in the administration of FEMA. Therules, regulations and norms pertaining to several sections of the Act are laid down by the Reserve

Bank of India, in consultation with the Central Government. The Act requires the Central

Government to appoint as many officers of the Central Government as Adjudicating Authorities for

holding inquiries pertaining to contravention of the Act. There is also a provision for appointing one

or more Special Directors (Appeals) to hear appeals against the order of the Adjudicating

authorities. The Central Government also establishes an Appellate Tribunal for Foreign Exchange to

hear appeals against the orders of the Adjudicating Authorities and the Special Director (Appeals).

The FEMA provides for the establishment, by the Central Government, of a Director of

Enforcement with a Director and such other officers or class of officers as it thinks fit for taking up

for investigation of the contraventions under this Act.

FEMA permits only authorized person to deal in foreign exchange or foreign security. Such an

authorized person, under the Act, means authorized dealer, money changer, off-shore banking unit

or any other person for the time being authorized by Reserve Bank. The Act thus prohibits any

person who:-

Deal in or transfer any foreign exchange or foreign security to any person not being an

authorized person;

Make any payment to or for the credit of any person resident outside India in any manner; Receive otherwise through an authorized person, any payment by order or on behalf of any

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person resident outside India in any manner;

Enter into any financial transaction in India as consideration for or in association with

acquisition or creation or transfer of a right to acquire, any asset outside India by any person is

resident in India which acquire, hold, own, possess or transfer any foreign exchange, foreign

security or any immovable property situated outside India.

The Act deals with two types of foreign exchange transactions.

C apital account transactions

Capital account transaction is defined as a transaction which:-

Alters the assets or liabilities, including contingent liabilities, outside India of persons

resident in India. In other words, it includes those transactions which are undertaken by a resident

of India such that his/her assets or liabilities outside India are altered (either increased or

decreased). For example: - (i) a resident of India acquires an immovable property outside India or

acquires shares of a foreign company. This way his/her overseas assets are increased; or (ii) a

resident of India borrows from a non-resident through External commercial Borrowings (ECBs).

This way he/she has created a liability outside India.

Alters the assets or liabilities in India of persons resident outside the India. In other words, itincludes those transactions which are undertaken by a non-resident such that his/her assets or

liabilities in India are altered (either increased or decreased). For example, (i) a non-resident

acquires immovable property in India or acquires shares of an Indian company or invest in a

Wholly Owned Subsidiary or a Joint Venture with a resident of India. This way his/her assets in

India are increased; or (ii) a non-resident borrows from Indian housing finance institute for

acquiring a house in India. This way he/she has created a liability in India.

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The Act also contains a list of some of the most common capital account transactions:-

Transfer or issue of any foreign security by a person resident in India;

Transfer or issue of any security by a person resident outside India;

Transfer or issue of any security or foreign security by any branch, office or agency in India

of a person resident outside India;

Any borrowing or lending in rupees in whatever form or by whatever name called;

Any borrowing or lending in rupees in whatever form or by whatever name called between a

person resident in India and a person resident outside India;

Deposits between persons resident in India and persons resident outside India;

Export, import or holding of currency or currency notes;

Transfer of immovable property outside India, other than a lease not exceeding five years, by

a person resident in India; Acquisition or transfer of immovable property in India, other than a lease not exceeding five

years, by a person resident outside India;

Giving of a guarantee or surety in respect of any debt, obligation or other liability incurred-

(i) By a person resident in India and owed to a person resident outside India; or

(ii) By a person resident outside India.

The Act has empowered the Reserve Bank of India (RBI) to specify, in consultation with the Central

Government, the permissible capital account transactions and the limits upto which foreignexchange may be drawn for these transactions. But it shall not impose any restriction on the drawal

of foreign exchange for payments due on account of amortization of loans or for depreciation of

direct investments in the ordinary course of business.

The permitted capital account transactions have been classified into two categories:-

Capital account transactions by persons resident in Ind